The GST and the hidden economy

This SMH report says the GST has done nothing to reduce the size of the hidden economy. I haven’t seen the original research on which the report is based. Also, although the reported method of looking at the volume of “unexplained” cash is widely-used in the literature on tax evasion, I have some technical difficulties with it. But the basic result is entirely predictable, and was in fact predicted by every competent economist who looked at the problem. Simon Grant and Stephen King (both then at ANU) did a nice analysis and someone else (can’t recall name right now) published much the same thing in the Economic Record.

The silliest of the claims made in support of substituting a GST for income taxes is that it will put a stop to tax evasion, of the kind practised, for example, by plumbers who are willing to charge a lower price in return for payment in cash. It should be obvious, at least to anyone trained in economics, that a change in names will change nothing; plumbers who fail to report their income to the Tax Office will also fail to report their sales to the officials responsible for the GST. For those who prefer a formal general equilibrium analysis, a paper by Simon Grant and Steven King proves that replacement of an income tax by a GST will make no difference in the extent or incidence of tax evasion.

I don’t know about an economist’s analysis, but here’s a practical experiential one. It certainly makes sense that a tradesperson (for example) will happily forego getting a 10% refund on GST paid for “inputs” if he/she can save 48.5% in tax. Having just finished a fairly large scale renovation splurge, I can testify that nearly all tradespeople are prepared to give a lower price for cash, the tax implications of which are obvious.

However, from the viewpoint of the consumer of services, it’s a bit different. If the services you’re acquiring are themselves for a profit-making business (e.g. a rental investment property as ours were), you need a tax invoice to be able to claim the expense as a deduction. Thus the above equation is effectively reversed. For a business consumer of services, it makes more sense to secure the tax deduction than to get a (say) 10% reduction for cash in the price of the services. Of course, this doesn’t apply to consumers acquiring services for their own homes, because those expenses are not deductible anyway. Moreover, I suspect that even some business consumers pay cash to get the lower price and then deduct the expense anyway. They’re gambling against a random tax audit.